It's a Collateral Crunch, Not a Credit Crunch

For the last few years I have argued that the housing situation was likely going to get worse. I also roiled against the increasingly complex “fancy financing” vehicles that allowed many home buyers to “lever” into homes they really could not afford. Still, the housing/financing bubbles continued to expand driven by the mantra, “you can’t lose money in real estate.” As with all bubbles, however, this one too has burst.

Nevertheless, I have opined that historically real estate has never pulled the economy into recession since it is an “effect” and not a “cause.” For example, in the early 1970s I moved to Atlanta and considered buying a $200,000 condominium. By 1975 that same condo was selling at bankruptcy auction for under $30,000. What happened? Well the “cause” was a rise in the price of crude oil with a concurrent rise in interest rates. The “effect” was a crash in real estate prices accompanied by a severe recession. Therefore, to think that real estate is going to pull the country into a recession one has to believe real estate has become so entwined in the economic fabric of the country that it has morphed from an “effect” into a “cause.”

In fact, according to some econometric models the odds of a recession are currently more than 50%. Plainly the country’s intelligentsia is worried as the Federal Reserve cut the discount rate a few weeks ago and took some pretty unusual “collateral” steps to help shore up the asset-backed commercial paper market (OTCPK:ABCP).

Those measures were designed to grease the rusty wheels of the credit system and allow the major banks to increase the amount of capital they can lend to the broker-dealer (B/D) complex, which is where much of the problem resides since the securitization of loans has transferred the risk from the banks to the B/Ds, hedge funds, etc. Interestingly, however, there has been only a token amount of borrowing at the discount window, suggesting that the banks seem to be more willing to tighten credit than to open the “money spigot.”

Such actions have raised cries of a credit crunch; however, I have argued that it is more of a “collateral crunch” than a real credit crunch. Verily, I have lived through credit crunches and by my pencil we are not yet in a true credit crunch. A credit crunch is when the banks quit lending money. So far, people with good credit can still get a conventional mortgage or loan just as easily as they could two years ago.

The risk is that the contagion spreads and morphs the collateral crunch into a full-blown credit crunch.

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So why is everyone so worried? Well, in addition to the recent seizing up of the ABCP market, which comprises 50% of the over $2 trln commercial paper market, this housing cycle looks different than any I have seen. To this point, I have included two charts. I suggest studying them carefully. What you find is that the 1988–1992 housing cycle peaked in the first quarter of 1988 (1Q88) followed by a decline in “For Sale Inventories” until the cycle troughs in the 4Q '91 (some 15 quarters later, which is typical).

Housing Inventory 1988-1992 vs. 2004-Present

Housing Vacancy Rates 1968-2007

A final observation: “Curiouser and curiouser,” cried Alice as she followed the rabbit down the hole... and in addition to the curiouser and curiouser action of T-bills, whose yield recently collapsed by an unprecedented weekly amount totally unconfirmed by a similar decline in the LIBOR rate, for the first time I can recall in nearly 40 years of looking, the Fed’s “free reserves” reading was negative (-499) last week as seen in Barron’s “Market Laboratory” on page M65.

Leasing Terms

In regards to Jeff Saut's observation "So far, people with good credit can still get a conventional mortgage or loan just as easily as they could two years ago." I heard a similar observation from a neighbor two houses away in regards to commercial leasing just this morning. I was out watering my lawn and my neighbor just finished his morning jog.

My neighbor works for the Royal Bank of Scotland, one of the largest banks in the whole world. In spite of a credit crunch, spreads on corporate leasing deals have collapsed. A couple of years ago deals were 400 basis points over cost of money, and although the RBS can obtain funds cheaper than most US banks and certainly lower than most US leasing corporations such as General Electric (NYSE:GE), RBS just lost a corporate jet leasing bid to GE that went at 47 basis points over cost of funds. If anything goes wrong with that deal it will be a money loser.

What has driven leasing spreads lower as spreads elsewhere are rising? It turns out that the number of corporations with good credit is not only shrinking, but the number of deals they want to do is shrinking as well. Competition is intense for new corporate leasing deals for customers with excellent credit.

And also in the “curiouser and curiouser”, department although GE "won " the bid, it was a larger piece of the pie than they wanted for from that particular customer. RBS was offered half the deal.

GE Weekly Chart

For now, the uptrend is still intact.

So, no problem yet borrowing money or getting good lease terms if your credit rating is top notch, but in regards to leasing there is little profit in the deals. And in regards to both mortgages and leasing, there is a dearth of customers with good credit risks that want to borrow.

And regardless of whether or not one calls this a collateral crunch or a credit crunch, (I think the former term works just fine given a Sudden Demand For Cash in many places) evidence continues to mount that profits from financing and financial services have peaked.